Behavioral Finance

The NBER's Working Group on Behavioral Finance, directed by Robert J. Shiller,
NBER and Yale University, and Richard H. Thaler, NBER and University of Chicago, met in
Cambridge on November 10. They discussed the following papers:

Andrei Shleifer, NBER and Harvard University, and Robert W. Vishny, NBER and University
of Chicago, "Stock Market Driven Acquisitions"

"Analyzing
the Analysts: Career Concerns and Biased Earnings Forecasts"

Discussant: Kent Womack, Dartmouth College

Brad M. Barber, University of California, Davis, and Terrance Odean, University of
California, Berkeley, "All that Glitters: The Effect of Attention and News on the Buying
Behavior of Individual and Institutional Investors"

Artyom Durnev, University of Michigan, Randall Morck, NBER and University of Alberta,
and Bernard Yeung, New York University, "Value Enhancing Capital Budgeting and Firm-Specific Stock Returns Variation"

Discussant: Jeremy C. Stein, NBER and Harvard University

Shleifer and Vishny present a model of mergers and acquisitions based on stock market
misvaluations of the combining firms. The key ingredients of the model are the relative
valuations of the merging firms, the horizons of their respective managers, and the market's
perception of the synergies from the combination. The model explains who acquires whom,
whether the medium of payment is cash or stock, what the valuation consequences of mergers
are, and why there are merger waves. The model is consistent with available empirical findings
about characteristics and returns of merging firms, and yields new predictions as well.

Goyal and Santa-Clara take a new look at the tradeoff between risk and return in the
stock market. They find a significant positive relationship between average stock variance and
the return on the market. Therefore, there is a tradeoff between risk and return in the stock
market, but risk is measured as total risk, including idiosyncratic risk, not simply systematic risk.
Further, the authors find that the variance of the market by itself has no forecasting power for
market return. These relationships persist even after the authors control for macroeconomic
variables known to forecast the stock market. Idiosyncratic risk explains most of the variation of
average stock risk through time and drives the forecastability of the stock market.

Hong and Kubik examine the career concerns of security analysts: they relate long
histories of their earnings forecasts to job separations. It turns out that relatively accurate past
forecasts lead to favorable career outcomes, such as remaining at or moving up to a high status
(large, prestigious) brokerage house. Controlling for analysts' accuracy, optimistic forecasts
relative to the consensus forecast increase the chances of favorable job separations. Job
separations depend much less on accuracy for those analysts who cover stocks that are
underwritten by their brokerage houses. Such analysts are also much more likely to be rewarded
for optimistic forecasts than other analysts. Furthermore, job separations have been much less
sensitive to accuracy and somewhat more sensitive to optimism during the stock market mania
of the late 1990s than at other times. These findings suggest that the well-documented "analyst
forecast optimism bias" is probably attributable to incentives to promote stocks.

Barber and Odean test the hypothesis that individual investors are more likely to be net
buyers of attention-grabbing stocks than institutional investors are. The authors speculate that
attention-based buying is a result of the difficulty that individual investors have in searching the
thousands of stocks they can potentially buy. Individual investors don't face the same search
problem when selling, because they tend to sell only a small subset of all stocks -- those they
already own. The authors look at three indications of how likely stocks are to catch investors'
attention: daily abnormal trading volume; daily returns; and daily news. They calculate net order
imbalances for more than 66,000 individual investors with accounts at a large discount
brokerage, 647,000 individual investors with accounts at a large retail brokerage, 14,000
individual investor accounts at a small discount brokerage, and 43 professional money managers.
The individual investors tend to be net purchasers of stocks on high attention days -- days when
those stocks experience high abnormal trading volume, days following extreme price moves, and
days on which stocks are in the news. Institutional investors are more likely to be net buyers on
days of low abnormal trading volume than days of high abnormal trading volume. Investors'
reaction to extreme price moves depends on their investment style. The tendency of individual
investors to be net buyers of attention-grabbing stocks is greatest on days of negative returns.
The authors speculate that this tendency may contribute to momentum in small stocks with
losses.

Stocks can be overpriced when constraints on short sales are binding. Jones and Lamont
study the costs of short selling equities between 1926 and 1933, using the publicly observable
market for borrowing stock. Some stocks are sometimes expensive to short, and it appears that
stocks enter the borrowing market when shorting demand is high. The authors find that stocks
that are expensive to short, or which enter the borrowing market, have high valuations and low
subsequent returns; this is consistent with the overpricing hypothesis. Size-adjusted returns are 1
to 2 percent lower per month for new entrants; despite high costs, it is profitable to short them.

A major issue in corporate finance is the extent to which managers' decisions enhance
firm value. Durnev, Morck, and Yeung show that capital budgeting decisions are more
consistent with value maximization in those industries whose stocks exhibit greater variation in
firm-specific returns. This finding argues against the view that variation in firm-specific returns
is simply noise, and supports Roll's (1988) view that it indicates activity by risk arbitrageurs. As
a result, the authors argue that corporate investment decisions tend to enhance firm value more
where there is more firm-specific risk arbitrage activity.